29 July 2011
The answer is obviously leverage.
Consider a hedge fund with an equity capital of $5 that borrows $95. It invests the money in the stock market.
At an interest rate of 0%, when the market rises 1% the fund earns a return of 20% on equity. Given five such days in a year when the market rises 1% the fund can easily earn a return of 100% on equity. Nice bonuses all around. Thank you, Mr Bernanke!
When the interest rate is 1% the annual cost of financing is 0.95%. So the market needs to rise nearly 2% to give a return of 20% on equity. If the market remains stationary, the fund undergoes a loss of nearly 20% on equity.
When the interest rate is 2% the annual cost of financing is 1.9%, so the market needs to rise nearly 3% to give a return of 20% on equity. If the market does not rise, the fund suffers a loss of 38% on equity.
When the interest rate is 5% the annual cost of financing is 4.75%, so the market must rise 5.75% to give a return of 20% on equity. If the market does not rise, almost all the fund's equity gets wiped out.
We have not considered staffing and other costs or the fact that a hedge fund can bet on the market's fall as well as its rise. But despite the simplification the idea is clear. Each percentage rise in interest rates increases the risk that a highly leveraged hedge fund can go bankrupt. It is not surprising, therefore, that a Fed Funds Rate of 5% is enough to pop most bubbles.
So what are the implications for policy? The US government has tried to set limits on bonuses, on the transparency of hedge funds and other financial institutions, on capital requirements and so on. I rather agree with Alan Greenspan that no regulator can keep pace with changes in financial engineering. To remove all risk from the system one would need to have a regulator looking over the shoulder of every trader. That would be going the way of the Soviet Union. And I doubt whether even that would prevent catastrophes.
On the other hand, a Fed Funds Rate of about 5% seems guaranteed to prevent any asset bubble from growing, judging from the past decade. But won't that also penalise businesses producing real goods and services? I have argued in Why banks do not lend at near-zero interest rates that both the economics and the evidence give the lie to this fear.
For a firm producing real goods and services, an interest rate of 10% probably won't add more than a percentage point or two to total cost. And this can easily be absorbed or passed on to customers. For financial trading firms, though, such an interest rate would be disastrous.
There is a curious corollary to the above thesis. I argued that raising the interest rate to moderate levels prevents any money from going to feed bubbles. Carrying the argument a step further, low interest rates, by diverting money to asset inflation, keeps the inflation of real goods and services down.
This conclusion militates against all common sense. In its favour, consider the fact that before the Great Depression, the crash in Japan, and the Great Recession, inflation was very low. That is to say, low inflation need not be a sign of slow monetary expansion, but quite the opposite: an indication that money is growing steeply.
24 July 2011
That meagre bank lending is due to, not in spite of, low interest rates is an idea that has never occurred to the Fed.
The logic behind keeping interest rates low seems to be as follows, to use an analogy. If the price of wheat is kept low, even the poor can afford it and demand will be high. Then, if the government supplies wheat at low prices to grocers, they will add a small mark-up and supply it to consumers.
The analogy seems apt, if you replace grocers by banks and the low price of wheat by the low supply cost of money. But in practice the analogy does not seem to have worked. Why?
To begin with, money is not wheat. When a grocer sells a kilogram of wheat to a customer he collects the price for it and that is the end of the transaction. When a banker lends money that is just the first leg of the transaction. He needs to get the money back and make sure that the value of the money he gets back is not only more than the value of the money he lent out but also meets all his costs and yields a profit besides.
During a period of near-zero interest rates the chances of this are bleak. The reason is inflation. If inflation is 0% when the bank lends at, say, an interest rate of 5% and is 5% at the end of a year when the load is repaid, the bank will have clearly sustained a large loss, if lending costs and provisions for bad loans are taken into account. And high inflation is not just a remote possibility. It is a certainty considering that it is the Fed's avowed aim to raise inflation. And given the Fed's record before and after the Great Recession, what guarantee is there that inflation will be just 5%? In such an uncertain situation why blame banks for not lending? Their chances of losing money are smaller if they don't lend than if they lend.
The other reason that banks don't lend when the cost of money is low is just plain common sense. But in an era of complex mathematical economics, common sense has been a prime casualty, so that I need to invoke an economist who has for long been held in considerable contempt: Alfred Marshall.
This is what he said in Principles of Economics (edition of 1920):
"If a person has a thing which he can put to several uses, he will distribute it among these uses in such a way that it has the same marginal utility in all. For if it had a greater marginal utility in one use than another, he would gain by taking away some of it from the second use and applying it to the first."
Now, loans are not the only use that money can be put to. Banks can also use money in trading, which has the singular advantage of not tying up money for long periods and so does away with the uncertainty connected with those long periods. If banks can earn profits through trading, they would naturally not risk making loans. The return of huge bank bonuses just a year after the financial crash is proof that this was what happened.
Why has such a commonsensical idea not occurred to the Fed or to most economists? I think the reason is that Keynesianism has held economics in thrall for more than half a century so that economists are unable to see past the demand side of an equation.
To illustrate the point he makes in the above quotation Marshall considers a housewife with a limited number of hanks of yarn who must make a decision about how to divide the yarn between making socks and making vests.
In the footnote he says:
"Our illustration belongs indeed properly to domestic production rather than to domestic consumption. But that was almost inevitable; for there are very few things ready for immediate consumption which are available for many different uses. And the doctrine of the distribution of means between different uses has less important and less interesting applications in the science of demand than in that of supply."
It almost sounds like an admonition to Keynesians from beyond the grave.
I hope readers will be interested in the following graph which plots a) Commercial and Industrial Loans at All Commercial Banks against b) the Effective Federal Funds Rate from January 2001 to June 2011 [The data are from (where else?) the web site of the Federal Bank of St Louis.]
Especially interesting is the period from around the beginning of 2001 when the Fed began to reduce interest rates to get out of a recession and kept reducing rates until the middle of 2004. All through that period, commercial and industrial loans shrank. From the middle of 2004 the Fed started raising rates to curb the housing bubble and immediately commercial and industrial loans began to rise.
Only an amazing coincidence, I'm sure.
09 July 2011
Now a couple of Bloomberg articles throw light on the sudden rise in money supply. See Lehman borrowed $18 billion from undisclosed Fed program during '08 crisis and Goldman Sachs took biggest loan from undisclosed 2008 Fed crisis program. The loans were made under a program known as the Fed's single-tranche open-market operations or ST OMO. The detailed information was released by the Fed after Bloomberg put in a Freedom of Information Act request for details.
The peak of the lending to units of 19 banks from 7 March 2008 to 30 December 2008 was $80 billion in loans outstanding. In the graph of Corrected Money Supply the sudden rise is about $130 billion. The difference is about $50 billion. I wonder whether there were any other secret loans to other parties under other programs.
The loans seem to have been put right back into trading in an effort to recoup losses but the effort failed and money supply plunged again.
06 July 2011The Sorrow and the Pity of Another Liquidity Trap
The note at the end says that DeLong is a professor of economics at the University of California, Berkeley. The content of the column makes this a bit difficult to believe but if Bloomberg says so it must be true. It also adds that he was deputy assistant secretary of the US Treasury. This is perfectly believable when you remember that it was during the time he served in office that the Glass-Steagall Act was finally killed.
This is what DeLong says in his column:
There is only one real law of economics: the law of supply and demand. If the quantity supplied goes up, the price goes down.
Back in the third quarter of 2008, the public held about $5.3 trillion of U.S. Treasury bills, notes and bonds. As the recession hit, tax revenue plummeted, and government spending rose, that total reached $9.4 trillion by mid-2011.
We're on target to have $10.7 trillion outstanding by mid-2012 -- doubling the Treasury debt held by the public in just four years. Supply and demand tells us that a steep rise in Treasury borrowings should produce a commensurate fall in Treasury bond prices and thus higher interest rates -- and that increase should crowd out other forms of interest-sensitive spending, slowing productivity growth.
Yet the market has swallowed all these issues without so much as a burp. By all accounts, it's smacking its lips in anticipation of the next tranches.
"If the quantity supplied goes up, the price goes down." Is this the law of supply and demand? I should think even a raw undergraduate knows that there is a proviso. If the quantity of a good supplied goes up while its demand stays constant, the price goes down.
So what makes DeLong think that the demand for government debt has remained constant? If you accept his figures then between the third quarter of 2008 and the middle of 2011, government debt increased by $4.1 trillion. During that period the two bouts of quantitative easing put about $2.1 trillion of cash into the hands of various players. That leaves $2 trillion to be accounted for. During the period the cumulative current account deficit was about $1.1 trillion and it's not too much to assume that a large chunk of this was used to purchase US debt. So that leaves just $0.9 trillion. And this is just peanuts when you remember the amount of cash sloshing around; US pension funds alone had about $9.9 trillion in assets as of 31 March 2010. [Flow of Funds Accounts of the United States quoted in Wikipedia Pension Fund]. Why wouldn't fund managers park some of their cash temporarily in US debt given the riskiness of other assets?
In other words just a couple of simple additions combined with the law of demand and supply (the real one, not DeLong's version of it) can easily explain why large issues of US debt have not raised interest rates much.
But since DeLong does not understand, or perhaps does not want to understand, demand and supply, he is surprised that interest rates have not gone up. To explain it he has to bring in the history of the Clinton and Bush administrations, the liquidity trap, the IS-LM diagram and much else, stopping finally only to scratch the back of Paul Krugman, a favour that will no doubt be returned next week.
Sometimes I am tempted to share Krugman's opinion of PhD economists. Never having learnt economics formally I am not in a position to say, but perhaps there is a sign at the entrance to university economics departments that says: "Abandon common sense, all ye who enter here."
Incidentally, according to Debt to the penny, between the start of 2011 and the middle of 2011 debt in the hands of the public has gone up from $9.4 trillion to $9.7 trillion, an increase of only $0.3 trillion, probably less than the amount of quantitative easing during that time.
03 July 2011Assessing Potential Financial Imbalances in an Era of Accommodative Monetary Policy at a Bank of Japan conference in Tokyo.
The speech does not mention the word 'bubble' even once but she was obviously referring to bubbles when she said:
"The severe economic consequences of the recent financial crisis have underscored the need for central banks to vigilantly monitor the financial system for emerging risks to financial stability. Indeed, such vigilance may be particularly important when monetary policy remains highly accommodative for an extended period. As many observers have argued, an environment of low and stable interest rates may encourage investor behavior that could potentially lead to the emergence of financial imbalances that could threaten financial stability."
Elsewhere she said:
"A sustained period of very low and stable yields may incent a phenomenon commonly referred to as 'reaching for yield,' in which investors seek higher returns by purchasing assets with greater duration or increased credit risk."
This is quite a change from, say, Ben Bernanke's statement on Asset-price "bubbles" and monetary policy on 15 October 2002:
"First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them."
Or from Alan Greenspan's statement on 17 June 1999:
"But bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgement that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best."
The rest of Yellen's speech is devoted to the parameters the Fed is keeping track of to ensure that there are no financial imbalances and concludes that though there is the stray worrying sign, overall there are no significant imbalances.
From the graph of Corrected Money Supply (Mc) that I have constructed I would seriously doubt this.
The steep rise in Mc in recent months and the fact that banks aren't doing much lending to firms suggest that their profits are coming from trading and taking on risk assets.
I am really curious to know why the large banks are cutting back on staff just after they've made such huge profits. Is it a sign that they are in trouble?